Editorial. Higher liquidity in commodity derivatives trade desirable, but with checks

The markets regulator, SEBI, has taken a significant step in giving foreign portfolio investors direct market access (DMA) in exchange traded commodity derivatives. DMA allows investors to directly enter trades into the exchange trading platform, using the broker’s trading system, but without any intervention of the personnel employed by the broker. This facility is needed for automated high frequency trades where a large number of transactions have to be executed at a fraction of a second, based on opportunities identified by trading algorithms.

This facility was allowed in the equity segment in 2008-09 and that had ushered in algo and high-frequency trading, giving a boost to trading turnover on the NSE. Trading volume on commodity exchanges could also jump once DMA is introduced, and that is welcome. Higher liquidity will bring down trading cost, increase market depth and improve price discovery. But the regulator should put in sufficient checks at exchange as well as broker level so that the move does not destabilise the market.

Indian commodity exchanges have not been growing at the same speed as equity markets. The market regulator has been trying to remedy this by increasing the participation of foreign portfolio investors. While earlier FPIs were only allowed to use commodity derivatives for hedging, last year, SEBI allowed them to trade on the exchanges without an underlying position. But SEBI has done well to restrict trading transactions of FPIs as well as the direct market access to non-agri commodity derivatives, which are cash settled. Agri-commodity derivatives, which are more politically sensitive, have not been opened for FPI trades. This implies that high frequency automated trades could begin in bullion, energy and base metal contracts on domestic commodity exchanges, which do not entail delivery of physical product. While trading volume will increase in these contracts, they will have minimal impact on the spot prices since the contracts are cash settled. Also, most of the non-agri contracts have a stronger link with prices discovered on global exchanges such as LME or NYMEX.

The regulator should try and avoid the mistakes made in the DMA trades in equity segment. Since algo trades are concentrated in the liquid counters, trading activity in equity cash and derivative segment has become very narrow. The top 100 securities account for 64 per cent of NSE’s cash segment turnover and Nifty 50 and Bank Nifty contracts account for a lion’s share of equity derivative turnover. Perhaps placing a limit on the DMA volume in each commodity contract per day could spread the activity across commodity exchanges. The limit can be increased periodically. The practices followed in equity segment such as stipulating the exchanges and brokers to audit the algo programs periodically and certify them as usable and asking brokers as well as exchanges to maintain records of all DMA transactions for audit trail should be followed in commodity exchanges too. Similarly, clients who flood the exchange server with orders should be penalised.

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